Understanding Initial and Variation Margin

Margin debt is the lubricant that greases the smooth functioning of the financial engines for markets around the world. Without initial margin, the requirement for cash or other assets to be put up to commence the buying and selling of the financial instruments on that exchange, there would be much less volume in the markets. As a result, prices would be much lower.

Initial margin lending stakes traders and investors in their beginning operations, generally doubling the amount they have in purchasing power. Lending the money that becomes margin is also very lucrative for financial houses. The greater the security in value, the more margin debt interest is earned by the lending firm. Margin lending is made even more attractive to a brokerage house as the asset is held in house: there is no home to foreclose or car to repossess. That is particularly so for contracts for differences (CFD), due to the unique nature of the financial instrument.

A contract for a difference (CFD) is a contract between two parties in which the seller will pay the buyer the difference in the value of an asset in the future. If the price rises, then the seller pays to the buyer the amount of the increase. Should the price fall, the buyer pays to the seller the difference in the asset value created by the decline.

Should asset values fall too much, variation margin is the additional amount that must be put up to maintain the correct ratio for an account to continue buying and selling. It is posted daily by trading firms with the clearing firms that settle CFD trading and other transactions. Variation margin is what maintains a needed level of liquidity in brokerage accounts, and thus the financial market as a whole.

As a financial derivative, a CFD allows for traders to profit from those prices that are rising by going long, or those falling, by going short. Do to the range of CFD usage, the margin requirements can swing widely. This results from CFDs being widely used and deployed to make a market on a wide range of asset classes.

Variation margin requirements can change, based on the security of the CFD and the market for that asset. Those CFDs based on stocks, as an example, are known as an equity derivative. Without owning any shares of the security, the seller and the buyer of a CFD can profit from the movement of the stock, depending on the position.

CFDs have been used since the 1990s as a low cost form of hedging. At present, CFDs can be bought and sold in the United Kingdom, Hong Kong, The Netherlands, Poland, Portugal, Romania, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand, Sweden, Norway, France, Ireland, Japan and Spain, but not the United States. The Securities and Exchange Commission does not allow the use due to its restrictions on over-the-counter financial vehicles.

The amount of margin required will fluctuate, based on the performance of the asset. Initial margin could be high for a novice trader. Should that person perform well, variation margin will result in less amounts of cash or securities to be retained as security. As variation margin is calculated on a daily basis, this provides an immediate snapshot of the financial health of a portfolio. Should it drop, the brokerage will sell assets in a “margin call” if the account holder does not provide more cash or securities to bring their portfolio up to the level of variation margin now required.